Tax reform won't cure nation's fiscal problems

Washington loves its panaceas. A few years ago, it was Army Gen. David Petraeus who could fix any problem — up to and perhaps including the presidency. Then it was the Simpson-Bowles commission, or maybe the congressional "supercommittee" on deficit reduction. Today's cure-all? Tax reform.

Tax reform "will result in the additional revenue the president seeks," House Speaker John Boehner said in his post-election news conference. "It will support economic growth, which means more revenue is generated for the Treasury. And it will improve the efficiency of the system, which means additional revenue as well."

That's the Washington consensus on tax reform: It slices, it dices, it cleans up after itself. But that's not the economic profession's consensus.

In 1997, Alan Auerbach and Joel Slemrod undertook an exhaustive survey of studies conducted after the 1986 tax reform. The results were mostly disappointing. The strongest effect they found was in "the timing of economic transactions" — for instance, the rush to take capital gains before a new, higher rate kicked in. After that, it was "financial and accounting responses," such as the effort to transform corporate income into individual income to, again, avoid higher taxes. All this is good news for tax lawyers, but what about moving the growth needle?

"At the bottom of the hierarchy is the response of real activities chosen by individuals or firms." On this, the authors concluded, the evidence is "mixed." Oh.

Over the past week, I've asked a dozen economists whether tax reform is likely to supercharge — or even kind of charge — growth. The consensus is summed up well by former White House economic adviser Lawrence Summers: "Given there's a need to raise revenue, doing it by closing loopholes is probably a better way to do it than doing it by raising rates," Summers said. "It can promote fairness, simplicity and resistance to special interests. But the idea that this is some important offensive growth strategy is implausible."

Bruce Bartlett, who helped write President Ronald Reagan's 1981 tax plan, is even more emphatic. "I am not familiar with any tax reform that raised growth, here or anywhere else," he said.

Washington policymakers are debating an approach — broadening the tax base through closing tax expenditures, credits and deductions — that isn't likely to do much at all.

Tax economists Alex Brill and Alan Viard explained the problem in a brief for the American Enterprise Institute. Their basic point is that if you're not cutting total taxes, you're not going to drastically alter the incentives people have to work. As a result, you're not going to see much added growth from tax reform, especially if the revenue contributed by various groups remains largely unchanged. All that should be pretty intuitive; if you're not changing who pays taxes or how much they pay, you're not changing all that much. Simplifying the tax code gets you only so far.

If Republicans and Democrats can agree on tax reform, however, it will almost certainly do more than simplify the code. It will increase taxes on the rich. And although there's no reason to expect that will harm the economy in a major way, it will probably create a slight drag on growth. "I think of tax reform more as a way of limiting the losses the tax increases bring," Auerbach says.

Another argument in favor of tax reform is that it will improve economic efficiency by letting the market, rather than the tax code, direct the flow of resources. Eliminate the exclusion for employer-provided health insurance and less money will flow to health care. Cap the mortgage interest deduction and housing won't be such an attractive investment.

"In their hearts, almost all economists believe that getting rid of tax expenditures will be good for growth because decisions will not be distorted by differences in taxes," said Michael Greenstone, an MIT economist who also directs the Hamilton Project at the Brookings Institution. "Unfortunately, I don't think there is much empirical evidence on this question either way."

Which isn't to say that tax reform isn't worth the effort. Everyone agrees that it can help a bit, and most everyone agrees that raising taxes by reforming the code is probably better for the economy than raising taxes by increasing marginal rates (though many caution that, given our fiscal problems, generating revenue is the most important goal and promises of higher revenue through tax reform often don't pan out). Tax reform doesn't slice, dice or cut through cans. If it's a "game changer," it is only in the sense that it gives the GOP a face-saving way to do what needs to be done: raise taxes.